building the forward curve concepts & methodology return to risk limited website:

________________________________________________________________________________________________________

Building the Forward Curve Concepts & Methodology

Return to Risk Limited website: www.RiskLimited.com

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Forward Curve Significance

• Forward Curve Development Is Crucially Important To Market Development– No Trades Without One

• Obviously Important To A Firm’s Forward Trading, Pricing And Hedging Activity– Lots Of Money At Stake In Emerging Market

Trading

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Forward Curve Significance

• Need Forward Curve Before Options Market Can Develop– Fundamental Necessary Step– Basis For Volatility Analysis

• Fixed Forward Pricing

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Requirements For A Forward Market

• Size Of Physical Market– Minimum Volume In Underlying Physical Spot

Trading

• Spot Price Must Exhibit Some Degree Of Volatility

• Coal Market In Prior Times Did Not Meet The Conditions Needed For Forward Market To Develop

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Sophistication Of The Market

• Financials

• Pricing Concepts– Not In Terms Of Physical Operation

Sophistication– Practitioners And Academic

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What Is The Forward Curve?

• Typical Definition Is…

• Forward Curve Is The Curve Representing The Prices At Which The Market Is Willing To Transact Future Business, Today.

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What It Isn’t

• Forward Curve Is Not A Predictor Of Future Spot Prices– Or Certainly Not A Good One– As Shown By A Number Of Academic Studies

Of Various Markets Such As Foreign Exchange

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Availability Of Price Indicators

• In Liquid Traded Markets A Question Of Sourcing The Data– Price Transparency– Or Difficult Access For Outsiders

• Possibly Some Difficulty In Access, But Not A Problematic Modeling Or Mathematical Issue

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Sourcing Market Data

• Lack Of Price Transparency– Private Market Affect– Standardization Of Transaction Hubs Or Index

Points– NG & Petrochemical Examples

• Survey Methods & Reporting– US NG At Basis Points Other Than Henry Hub

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Overcoming The Lack Of Data

• An Issue Faced In Each Emerging Market– Common Problem, But…– Not To Say It Is Easy Or Has A Standard

Solution

• Degree Of Difficulty Posed Depends On Characteristics Of Each New Market

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Historical Pricing

• Known Seasonality Pattern In Historical Pricing

• But What If There Are No Historical Prices– Meaning, No Price History Of Spot Prices– In Some Emerging Traded Markets, There Has

Not Been Forward Physical Trading, No Futures, No OTC Forward Financials Like Swaps – But …

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Historical Pricing

• If There Is A Known Price Series Of Historical Spot Prices

• Or Relevant Spot Prices– Structural Change Of Market (NG)– No Published Or Accessible Transaction

Pricing (Steel)

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Building The Curve

• In New Or Illiquid Markets– What Are The Alternatives For Building The

Curve?

• Unfortunately, No Standard Or Easy Solutions

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Building The Curve

• Similar Need May Arise In Active Or Mature Markets For Development Of Long-Dated Pricing Curve– Taking The Forward Out 5, 10, or 15 Years

• Typically, A Bit Less Problematic In That Spot And Short-Term Price Histories Exist– Market Familiarity & Sophistication Exist

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Emerging Market Examples

• Forward Curve Development Is A Concern In The Power Markets– But Concept Is Not A New Issue

• Same Issue Arises In Every Emerging Market, By Definition

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• For Example…

• US Natural Gas Market, 1991– Now Well Established 20 Year Curve

• Petrochemicals Market, 1997– Still Evolving, But Multi-Year Curve For

Select Products

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• Pulp (& Paper) Market, 1994– Trading & Forward Pricing Development Has

Languished– For Other Structural Reasons

• Coal Market, 1999– Developing Rapidly

• Steel, 1995– Languished

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Power Market Uniqueness

• Special Complexities In Power Markets Such As US With Extreme Price Volatility

• Determining A Probable Range Is The Best Goal– Not Absolute Precise Forward Curve, But

Logical Range– Model Output Best Not Treated As A Precise

Point Estimate

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Categories Of Modeling Approaches

• Cash & Carry

• Econometric

• Arbitrage

• Constrained Interpolation & Extrapolation

• Market Maker / Intuitive

• None Are Perfect, Precise, Or Easy, But…– In Aggregate May Provide Range Boundary

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Modeling Approaches – Cash & Carry

• Simplistic Model– Also Referred To As Cost Of Carry

• But Applicable In Some Physical Commodities & Financial Assets

• A Starting Point

• Not Directly Applicable In Power Because Electricity Is Not Storable

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Modeling Approaches – Econometric

• Fundamentals Projections• Supply / Demand Balance

– Current & Future

• Establishing Components In Supply & Demand Equation

• Modeling Factors Influencing These Components In The Future

• Poor Performance Record As A Predictor

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Modeling Approaches – Arbitrage

• Between Prices Available For Future Dates On Different Markets Or Instruments– Futures, Physical Forwards & Fixed Price Swaps

• Growth Of One Market Or Instrument Can Support Another In Price Discovery

• Value Of Having Futures Markets With High Transparency To Support OTC Swaps Development

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Modeling Approaches – Interpolation & Extrapolation

• Uses Limited Number Of Known Forward Transaction Prices To Establish A Full Curve– With Assumed Guidelines & Constraints, Such

As Seasonal Pricing, Mean Reversion

• Perhaps Not As Sophisticated A Method, But Popular And Possibly Useful

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Modeling Approaches – Market Maker Or Intuitive

• Specialized Participant Willing To Make Prices In Illiquid Markets– May Be Intuitive Pricing Rather Than

Mathematical Model Driven, But Effective If Exists

– Long-Term US Natural Gas Market Development

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Econometric Modeling

• All Factors Affecting Current Supply & Demand Should Determine The Current Price– Spot Pricing Based On Supply/Demand Balance– Absent Constraints

• Supply / Demand Balance At Some Future Time Point Should Determine Future Price– If The S / D Factors Could Be Predicted

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• The Forward Curve Is Not A Forecast

• It Is Not A Predictor Of Future Prices

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Regulatory Considerations – Affecting Fundamentals

• A Wild Card Driving Fundamentals– Difficult To Predict– Contributes To Uncertainty In Forward Pricing

• Predicting The Political Process– How?– When?

• Prior US Power Market Example

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• Highlights The Weakness Of Econometric Approach – Uncertainty Of Inputs

• Even If An Accurate Deterministic Model Formula Can Be Constructed

• Running Of Deterministic Solutions With Different Scenario Inputs Or Distributions To Establish Probable Boundaries

• And Estimating Variability & Certainty

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Arbitrage Modeling

• Based On Correlation Of Market Prices

• Stability Of Correlations

• Correlations Tend To Break Down When You Need Them

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Arbitrage Modeling

• Based On Assumptions Regarding Correlations Between Markets– And Stability Of That Correlation Level– Does Not Necessarily Require That There Be A

Perfect Price Correlation

• Petrochemical And US Power Examples

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Arbitrage Modeling – US Power Example

• A Primary Basis Of Pricing At Beginning Of US Wholesale Power Market– Major Market Makers Were Enron & DLD– From Financial, Not Physical Markets Side– With Extensive Experience In Gas

• Trading The Presumed Spark Spread

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Arbitrage Modeling – US Power Example

• For Each Region– Modeling Supply Curve– Generation Mix– Conversion Or Heat Rates– Expected Participant Behaviors

• Likely Transmission Constraints Between Regions

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Petrochemicals Forward Market Development

• Huge Physical Market

• Lack Of Price Discovery– Established Indices– Concentration Of Market In Some Products On

Both Supply And Consumption– Fragmented Products– But Standard Specifications

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Arbitrage Modeling – Petrochemicals

• Primary Basis Of Forward Pricing Petrochemicals Swaps Market– Major Market Makers, Enron, Dreyfus &

Morgan Stanley– Econometrics Supply / Demand Modeling

Quite Complex And Uncertain On Supply Side

• Surrogate Hedging With Ratios Of Oil Complex

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US Natural Gas Evolution

• Futures Began Trading April 4, 1991– During Period Of Rising Price Volatility

• Over-The-Counter Market Trading Had Already Begun

• Demand High For Very Long-Term Hedge Instruments For NG Price Exposure On Project Finance [IPP’s]

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Interpolation &Extrapolation

• Basis Of Some Of The “Black Box” Models Offered By Some Firms

• Another Reference Point In Estimation Of A Probable Range Or Distribution Of Forward Prices

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• Uses Scarce Number Of Known Transactable Forward Prices To Establish A Full Curve– Presumption That Some Valid Data Points On

Bid / Offer Are Known– For Active Participants Likely That Some Few

Select Transacted Deals Will Be Done Or Observed Past Normally Quoted Forward Curve

– Shows The Value Of Vigorous Market Information Gathering

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• Extrapolation And / Or Interpolation Is Used With Imposed Constraints– Provided By Model Supplier Or Input By User

• For Parameters Such As…– Predicted Mean Reversion Level– Observed Seasonality Of Prices– Observed Relationship Of Volatility To

Absolute Price Levels

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Cash & Carry

• Cash And Carry Arbitrage– Referring To Risk-Free Arbitrage – Not “Spec’ing The Market”

• Indicates The Maximum For Forward Prices

• And Is Transactable To Drive The Market Pricing In Line

• Picking Up Dimes In Front Of Steamroller

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Cash & Carry Factors

• For Commodities, Cost Of Carry Typically Includes:– Storage Charges & Input / Output Handling Fees– Any Incremental Transportation To / From

Storage Facilities– Cost Of Funds– Insurance, Taxes, & Any Other Logistics Fees

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Cash & Carry Application

• Why Not Applicable For Power Markets?– No Electricity Storage Available, Or At

Least Not Meaningful Amounts Of Storage– Even If Considering Pumped Storage– Is Hydro Storage?

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Cash & Carry – US Natural Gas Example

• Suppose The Spot Cash Market Price For Natural Gas Is US$ 2.00 / MMBtu

• And The Cost Of All Storage, Storage Related Fees, And Insurance Is US$ 0.25 / MMBtu Per Month

• The Yield On A 1-Month T-Bill Is 6%• Then The Maximum Forward Price For The

Same Location Point Should Be US$ 2.7625

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• Backwardation & Contango

– Why Would A Commodity Forward Curve Be Downward Sloping (In Backwardation)?

Forward Curve Standard Shapes

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Forward Curve Standard ShapesForward CurvesWTI Crude Oil Prices

1 3 5 7 9 11 13 15 17 19

Time (Months)

Series1

Series2

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Crude Oil Forwards Market

• Why Is The Crude Oil Curve Typically In Backwardation?

• For Total US Market Consumption, Only A Few Days Of Total Storage

• Hence Market Is Willing To Pay A Prompt Premium

• What Would Swing Curve Into Contango?

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• Equivalents In Capital Markets

• Inverted & Normal Curves In Interest Rate Markets

Forward Curve Standard Shapes

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• Trader’s View On Indicated Forward Bid Offer Range– Back-To-Back Capability– Willingness To Make A Price

• Degree Of Difficulty, Degree Of Certainty

Market Maker Approach

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Market Makers

• Market Makers May Have Hedge Techniques Or Mechanisms Not Available To Others– Which Allows Them To Take “Spec” Positions

With Risk Profiles Unacceptable To Other Market Participants

• To Trade It, Need To Be Able To Price It And To Hedge It

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Market Makers

• Existence Of Market Makers In A New Market– To Establish A Clearing Price– Two-Way Market, Bid / Ask Pricing

• “Any Deal At Some Price”

– “But You May Not Like The Price”

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Testing Market

• Exploring Market For Forward Transactional Prices– Bid / Offer Spreads

• Market Maker Technique

• Important Role Of Brokers As Intermediaries Providing Price Discovery

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Cobalt Example

• Well Known Transactional Spot Pricing– No Forwards, Futures, Swaps– No Forward Transactional Activity Of Any

• Highly Concentrated Market In Supply And Consumption Sides

• Extreme Instability In Supply– Volatile Price

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Cobalt Example

• Truly Undeveloped Forward Market– But Valuable To Have Had Spot Price Histories

• Cost Of Production

• Average Prices In Stable Periods

• But Structural Changes Of The Market

• Bank Was In Unique Market Maker Role– Profitability Exceptional

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Conclusions

• Any Actual Transaction Pricing For Future Dates Is Valuable Input In Deciphering The Full Forward Curve– Even If Differing Tenors Than Forward Time

Point Most Of Interest To You– Even If In A Different Instrument [Futures,

OTC Fixed Price Swaps, Forward Physicals]– Or From A Highly Correlated Market

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Conclusions

• Other Prior Emerging Markets Offer Some Guide To Probable Directions For Power Curve Development– But Unique Complexities In Power

• Pros & Cons For Each Of The Various Estimation Approaches And Techniques– Best Used In Aggregate

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Conclusions

• Recognize Model Output As Estimate, Not Absolutes

• Best Objective Is Projecting A Useable Range For The Forward Curve

• Considerable Resources In Quantitative Research And Trading Market Intelligence Need To Be Applied For Best Curve Development

R IS K L IM IT E D C O R P O R A T IO N...inn ova tion a nd exp ertise

building the forward curve concepts & methodology return to risk limited website:

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